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Trillion-Dollar Firms Dominating Bonds

SEC probes into the bond market were prompted in part by lopsided growth since 2008; the two largest firms now manage $3 trillion in bonds.

Some of the largest hedge-fund firms, including Bridgewater Associates LP and BlueCrest Capital Management LLP, have also more than doubled their investments in debt, data compiled by Bloomberg show. At the same time, Wall Street banks are shrinking their stakes in bonds, Federal Reserve data show.

The lopsided bond market has caught the attention of the U.S. Securities and Exchange Commission. Not only is the SEC examining whether the biggest players get preferential prices and access because of their influence, it’s also worried about what happens when the five-year bond rally ends as U.S. policy makers prepare to raise interest rates.

“It’s going to be interesting to see who’ll take the other side of the trade if there’s a meaningful sell-off, which presents a huge risk,” said Arthur Tetyevsky, a credit-trading strategist at Imperial Capital LLC in New York. “We’re much closer to the end of the rally, that’s for sure.”

The biggest funds’ dominance may make it harder for everyone to sell when the Fed boosts borrowing costs from record lows and sends bond prices tumbling. In essence, their selling may crowd narrowed exits, making it more painful as all investors race to get out of a falling market.

While regulators have looked at the threat to the financial system posed by too-big-to-fail banks, hazard has migrated to money managers. Banks, facing stiffer restrictions on borrowing and the amount of cash they need to keep on hand in the aftermath of the credit crisis, have cut the amount of their own money they use to help clients trade. That reduced role leaves the bond market more vulnerable to ripple effects from the actions of the behemoth managers.

More than five years of near-zero interest rates from the Fed have propelled corporate bonds to record performance, and the biggest debt managers have ballooned in size. Pimco, Vanguard Group Inc., and Fidelity Investments manage 39 percent of all mutual fund-owned taxable bonds today, up from 18 percent in 1997, according to Morningstar Inc. data. The smallest 205 fund providers manage 0.1 percent of the market.

Bond Oligarchy

“When it comes to fixed-income management, there is an oligarchy,” said Robert Smith, chief investment officer at Austin, Texas-based Sage Advisory Services Ltd., which oversees about $10.5 billion. “That can be good and that can be bad. It’s bad when you have a market that’s feeling like it’s weak and not doing well and selling off.”

Just because an investment firm is big doesn’t mean it poses more risk to the financial system, according to BlackRock. Rather than size, regulators should look at how much borrowed money a fund uses as a way to screen for systemic importance, it said in an April 4 letter to the Financial Stability Board. BlackRock said it uses very little leverage across its funds.

“The fact that some firms have gotten larger and some firms have gotten smaller, I’m not sure that’s relevant to secondary trading,” said Richard Prager, head of trading and liquidity strategies at BlackRock. “You have to think about it in terms of the different funds. It’s going to affect all of them equally if the dealers are all shrinking.”

Mark Porterfield, a Pimco spokesman, declined to comment, as did Ryan FitzGibbon, a spokeswoman for Bridgewater, and Ed Orlebar, a representative for BlueCrest.

At the same time, regulators are examining the way larger firms benefit in markets where transactions are often executed the same way they were a decade ago—through telephone conversations and emails.

In this two-tiered market, brokers choose which rivals and clients may see their bond prices on electronic trading systems by turning quotes on and off. Dealers often give bigger investors better prices in return for all of the business they do with Wall Street.

The SEC is examining to what extent smaller buyers are disadvantaged, and whether the behavior constitutes market manipulation, according to two people with direct knowledge of the matter who asked not to be identified because the probe hasn’t been made public.

“For the do-it-yourselfer, the disadvantages are growing by leaps and bounds,” said Marilyn Cohen, who manages $315 million of corporate and municipal bonds as founder of Envision Capital Management Inc. in El Segundo, California. “There’s a smaller and smaller market for money managers that aren’t the size of BlackRock and Pimco.”

Worse Prices

Investors typically get worse prices when they trade smaller blocks of bonds. One day last month, dealers sold $15,000 of steel company ArcelorMittal SA’s bonds maturing in 2041 for 3.5 cents on the dollar more than they paid to buy $25,000 of the same securities an hour later. By contrast, two exchanges of $100,000 or more of the debt that day were within 0.05 cent of one another, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority (Finra).

It’s getting tougher to trade bonds as the business gets less profitable for Wall Street. Corporate-debt trading volumes in the U.S. have failed to keep pace with issuance, increasing 14 percent since 2010 as outstanding notes grew by 33 percent, according to Finra and Bank of America Merrill Lynch index data.

Requirements that banks hold more cash in the event their investments tank have prompted dealers to reduce their inventories, giving the biggest managers even more sway in the market. The largest dealers had slashed their holdings of corporate bonds to $56 billion as of a year ago from $235 billion in 2007, according to Fed Bank of New York data. The inventories worked to cushion against price swings and made it easier to trade in larger sizes.

“There may be limits to what regulation can achieve,” New York Fed analysts Samuel Antill, David Hou, and Asani Sarkar wrote in a March 27 report. “Financial growth has occurred in the more opaque and harder-to-regulate sectors,” they wrote.

Biggest Funds

All bondholders are hurt when the biggest funds unload securities. When investors yanked a record $61.8 billion from broad-market bond funds in the first nine months of last year, it helped spur about $410 billion of losses on $20.5 trillion of U.S. government and corporate debt, Bank of America Merrill Lynch index data show. That was the securities’ worst performance since 1994.

Benchmark 10-year Treasury yields rose to 2.64 percent at 10:20 a.m. in New York after earlier touching 2.6 percent, the lowest level since March 3, according to Bloomberg Bond Trader prices. The yield climbed to 3.05 percent on Jan. 2, the highest since July 2011.

Barclays Plc strategist Jeff Meli said in August flows are “showing up real time in performance” since dealers aren’t buffering against such lurches as much as they used to.

The New York Fed routinely monitors market liquidity as part of its financial stability role for the central bank, and officials are seeing what they can learn from last year’s bond market sell-off. New York Fed researchers wrote in an Aug. 5 blog post the sell-off was “steeper than most historical episodes.”

The funds that attracted the most assets in the previous four years experienced some of the biggest withdrawals. The world’s largest bond fund, Pimco’s Total Return Fund, for example, reported $8.3 billion of outflows in the first three months of 2014. That overwhelmed $6.4 billion of inflows into the rest of funds in its category, Morningstar data show.

The largest bond-fund managers have been able to amass a disproportionate amount of securities over the past five years partly by getting first dibs on new corporate-bond sales. The SEC is also investigating whether banks are fairly divvying up new issues and whether they give preferential treatment to top clients.

Bankers gave almost half of Verizon Communications Inc.’s record $49 billion bond sale in September to just 10 companies, people with knowledge of the matter said at the time. The price instantly jumped, handing those buyers about $2.5 billion in gains just one day after issuance.

Pimco Buys

Newport Beach, California-based Pimco purchased $8 billion of the Verizon debt and BlackRock bought about $5 billion, people familiar with the sale said at the time. Fink, 61, is chief executive of New York-based BlackRock and Gross, 70, is chief investment officer and co-founder of Pimco.

Robert Varettoni, a spokesman for Verizon, declined to comment on last year’s bond sale.

“With the bond market, you want to be big,” said Michael Rawson, an analyst at Morningstar in Chicago. “If you’re too small, it’s hard to get a decent allocation and good pricing.”

Being big can cut costs by having many different funds rely on the same people to trade, analyze, and process specific bonds.

“They can lower their fees,” said Andrew McCollum, a managing director at Greenwich Associates in Stamford, Connecticut. “That’s the reason the big managers are getting bigger—they can basically do the same thing for a lower cost.”

BlackRock oversees $1.2 trillion of debt, compared with $483.2 billion in December 2008, according to the firm’s financial filings. Pimco manages $1.9 trillion of assets, with more than 90 percent in bond-related funds, versus $960 billion of assets five years earlier.

Enjoying Perks

Bridgewater’s All Weather fund, which emphasizes debt-related investments, has quadrupled since the end of 2009 to about $80 billion in assets, according to data compiled by Bloomberg. BlueCrest, co-founded by former JPMorgan Chase & Co. proprietary trader Michael Platt, has expanded to include about $32 billion of assets since its 2000 inception.

Hedge funds with more than $1 billion under management hold 59 percent of debt assets among similar firms, up from 29 percent in 2008, according to data compiled by Eurekahedge Pte Ltd., an alternative investment research firm, on relative-value strategies.

While they enjoy perks, bigger funds can also have a harder time being nimble as trading falls as a proportion of the total market.

Pimco has faced withdrawals at the same time former Chief Executive Officer Mohamed El-Erian resigned in January.

The company’s $232 billion Total Return Fund produced the worst risk-adjusted return over the past year among 16 U.S. intermediate-term funds with at least $5 billion in assets, according to the Bloomberg Riskless Return Ranking. As shorter- maturity debt tumbled in anticipation of rising interest rates, Gross’s fund posted the second-worst returns and second-highest volatility in the group.

When Gross sells, it resonates throughout the market -- and a world of falling bond prices may be about to take hold. Analysts surveyed by Bloomberg predict yields on the 10-year Treasury will climb to 3.33 percent at year-end and reach 3.60 percent in the first half of 2015.

The SEC’s priorities for the year include monitoring “the risks associated with a changing interest-rate environment and the impact this may have on bond funds,” according to a January memo from the agency’s Office of Compliance Inspections and Examinations.

“There’s a market until there isn’t one,” said Tim Gramatovich, who helps manage more than $800 million as chief investment officer of Santa Barbara, California-based Peritus Asset Management LLC. “What happens when there’s no bid?”

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